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The rate that stops a nation

Forget the Melbourne Cup. It may be the race that stops the nation, but nowadays it’s more the rate that can stop the nation. On the first Tuesday of every month (with the exception of January), the Reserve Bank of Australia determines whether interest rates will go up, down, or stay the same. As 2.30pm strikes, all eyes are on the outcome.

The Reserve Bank’s role

As the central bank of Australia, the Reserve Bank’s role is to keep the economy on the right path through the implementation of monetary policy. Its aim is to ensure that the inflation rate stays within a 2-3 per cent band so that Australia can enjoy a stable currency, full employment and economic prosperity. The tool it uses to influence this is the cash interest rate.

If the economy is going full bore and spending is getting out of hand, then the RBA may move to raise interest rates to stifle demand. In contrast, if the economy is slowing, the RBA may lower rates so that it frees up more money for you to spend in the economy.

But what do the central bank’s changes to the base rate mean to you? Well, ultimately they will impact on what you pay for any loans you may have and what you will earn for any deposits.

So if the RBA lifts rates by 0.25 per cent (or 25 basis points), then the chances are your lender will also raise your mortgage rate by the same 0.25 per cent.

Most lenders tend to pass on the entire increase, and sometimes even more, though Treasurer Swan has recently warned financial institutions against doing this.

Cost of funding

The other major influence for lending institutions when reviewing interest rates is the cost of funding. Most of the funds lent to homebuyers and businesses come from the wholesale market (both here and offshore) and customer deposits.

According to economist Saul Eslake of the Grattan Institute, some 40 per cent of the banks’ funding comes from the wholesale market.

“In the past the short term wholesale cost of funding used to align pretty closely with the cash (base) rate but with the onset of the financial crisis in mid-2007, the relationship began to break down,” says Eslake. “These days there is just a loose correlation although it is still an influence.”

Before the credit crunch, the wholesale rate used to be about 10 basis points higher than the cash rate. At the height of the crisis, the gap jumped to 130 basis points. It’s now back down to around 25-30 basis points difference.

According to Canstar Cannex, the 90 day bank bill swap rate is the best indicator of the wholesale rate, and it is sitting at 4.39 per cent. This compares with the base rate, which is currently 4 per cent.

One of the main reasons why many of the banks have been seeking to raise rates above and beyond the base rate increases announced by the RBA is because during the global financial crisis, the cost of funding became more expensive as money became scarce.

Indeed that scarcity also explains why the Government introduced the wholesale bank guarantee to ensure our financial institutions could enjoy a AAA rating when borrowing on overseas credit markets. By guaranteeing the local financial institutions, it meant they could borrow money at a lower cost from the wholesale markets which in turn meant mortgage rates were kept down. The lifting of that guarantee from April 1 indicates that the Government believes those difficulties have now passed, with margins between the rate the banks borrow and the rate they lend being now back at pre-crisis levels.

But even if the lenders increase rates by more than the base rate movement, Eslake says the RBA takes this into account when setting future rates.

Check your loan

With rates on the rise as they are now, and with Reserve Bank governor Glenn Stevens pointing to potential further rises, it’s a good idea to regularly keep an eye on what is happening in the market so that you can make sure you are getting the best deal available.

Eslake, however, believes the time has now passed for fixing rates, although there can still be an argument to do this to part of your borrowings to give you some certainty about your future repayments.

Check what your current variable loan has to offer and whether you can refinance at a lower rate. Other loans may be without some of the features that your current mortgage offers, but if you don’t use those extra features, you may save thousands in repayments. So, by checking your loan, you may be well on your way to backing a winner.

Information on the rates quoted are correct as at 05/04/2010, but subject to change.

About Jim Rice

Jim hails from California but now calls Sydney's Inner West his home. He is passionate about learning and teaching both digital technology and personal finance. In his spare time you'll find him either chasing his daughter around town or in the surf.

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